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Tuesday, September 01, 2015

Letter to FASB regarding the accounting treatment of deferred U.S. taxes

I am one of eight signatories of a letter that has just been sent to the Financial Accounting Standards Board, urging it to repeal APB 23, the rule that allows U.S. companies to designate particular foreign earnings as indefinitely reinvested abroad, thus allowing U.S. deferred tax liabilities to be ignored rather than being deducted from reported earnings at full value.

APB 23 has terrible tax policy effects, as it creates lock-in for foreign earnings insofar as managers who have taken advantage of it don't want to create negative adjustments (or to undermine their ability to make other APB 23 designations in the future). But it also is absurdly discontinuous (causing deferred U.S. taxes to jump from being deducted at full value to being wholly ignored) and excessively discretionary - as I feel I can say, despite not being an accountant, both from having talked to accountants and from the overlap between accounting and legal rule design with respect to income.

I would be (pleasantly) surprised if FASB took notice of this letter in any way. But I see it as a useful contribution to public debate about the issues (including before Congress), and wish to thank those who took the lead in creating this letter.

Anyway, here is the text of the letter (which, it is not hard to tell, reflected the lead input of individuals more knowledgeable about financial accounting than I am):

August 31, 2015

Financial Accounting Standards Board

Norwalk, Connecticut

Dear FASB Members,

We encourage
Members of the Financial Accounting Standards Board to repeal Accounting
Principles Board Opinion No. 23, the rule that allows a company to make a
designation of indefinitely reinvested earnings (IRE) to suppress a U.S.
deferred tax liability (DTL) that otherwise would be reported as contingent on
the repatriation of deferred foreign earnings.[1]

We are
concerned that APB 23 IRE designations undermine accounting credibility and
contribute to bad tax policy. The
designations are an incentive to reduce domestic economic activity and the U.S.
tax base by encouraging investment in low tax jurisdictions. Further, the designations invite real or
perceived management conflicts of interest, creating vulnerability for IRE reversals
(including reversals that have already occurred) that damage public accounting.[2]

While
pending legislative action could moot company interest in IRE designations, it
is important for FASB to recognize that the accumulation of foreign deferral
attributable in part to APB 23 has contributed to the advocacy for another
repatriation holiday and/or replacing current law with a more territorial
system. There may be no better example
of the power of accounting than this case in which suppression of a DTL for
book purposes (about which some accountants and others have had concerns from
the beginning) could end up forcing a corresponding tax law change to exempt
foreign earnings from U.S. tax, a result that might not be a possibility if APB
23 had not been adopted or the Opinion had been implemented more rigorously.

In
addition to APB 23’s effects on tax policy, we note three non-exclusive accounting
concerns, none of which was addressed in detail when APB 23 was approved 43
years ago or since:

1.As the “Quad B” dissenters to APB 23’s adoption
warned in 1972,[3] the suppression of DTLs under APB 23 may misinform investors looking
at book income by mixing restricted earnings (i.e., income for which IRE
designations are made) with unrestricted earnings.

2.APB 23
requires management to assert the unknowable in order to achieve the
book income advantage of suppressing a DTL.[4]
Companies cannot reliably assert,
whether as a probability or a possibility, that certain income will not be repatriated
in the next 20 or 30 years (which is how “indefinitely” needs to be defined for
accounting consistency).[5]
Changes in management, business
circumstances, and shareholder needs make such assertions impractical (as
demonstrated by recent big and small reversals of IRE designations by companies
including Avon, eBay, Pfizer, and General Electric). Prudent accounting requires
use of the DTL, which is ideal for accommodating long-term book/tax
differences, to remind investors of the inevitable cost of repatriation.

3.The inconsistency
of ABP 23 with Financial Accounting Standards No. 52 further muddles
book income reporting and creates inequities across companies. FAS 52, which
requires currency translation of certain foreign-denominated items for book reporting,
does not permit the kind of broad company discretion to suppress a bad book
result that is allowed by APB 23 (which can enhance book income by suppressing DTLs) even though there are similarities in
company decision-making for repatriation and currency conversion.[6]

Because
of the interaction between accounting rules and tax law, we believe both would be
served by repealing APB 23, and we would be happy to discuss ideas for
transition that would minimize disruption and complexity. At the very least, FASB would well serve the
public and itself by addressing tax and accounting controversy surrounding the
Opinion.

Sincerely,

Patrick Driessen

Revenue Estimator, Federal Government (retired)

J. Clifton Fleming, Jr.

Ernest L. Wilkinson Professor of Law

J. Reuben Clark School of Law

Brigham Young University

Jeffery M. Kadet

CPA (retired) and Adjunct Lecturer

University of Washington School of Law

Edward D. Kleinbard

Johnson Professor of Law and Business

University of Southern California Gould School of Law

David L. Koontz

CPA (retired)

Robert J. Peroni

Fondren Foundation Centennial Chair for Faculty Excellence
and Professor of Law

University of Texas School of Law

Daniel N. Shaviro

Wayne Perry Professor of Taxation

New York University School of Law

Stephen E. Shay

Senior Lecturer

Harvard Law School

[1] FASB’s decisions on February 11, 2015, to require
disclosures of pre-tax earnings sources and further information about tax
expense, APB 23 reversals, and IRE designation amounts for certain countries
are helpful but in our opinion do not address fundamental issues.

[2] With over $2 trillion of IRE designations, roughly
$500 billion of DTLs have been suppressed just in the last decade under APB 23
since the 2004 repatriation holiday.
These numbers are so large relative to other financial statement entries
that it would not take much in the way of reversals to cause noticeable
effects. The DTL suppressions under APB
23 by many U.S. multinationals exceed their existing DTLs, deferred tax assets,
and approach the magnitudes of inventories and accounts receivable
entries. For example, in 2014 Apple’s own
estimate of $23.3 billion of suppressed DTLs (associated with IREs of $69.7
billion) exceeds its $6.5 billion of DTAs, $20.6 billion of net property,
plant, and equipment, $17.5 billion of
accounts receivable, and approaches its $29.0 billion of long-term debt. While Apple’s ratio of APB-23-suppressed DTLs
to total assets may be relatively large at 10 percent ($23.3/$231.8) compared
to other companies, a perusal of companies (e.g., General Electric) suggests that
ratios of about 5 percent are routine.

[3] While 14 Members of the APB viewed the Opinion as an
improvement in accounting accuracy, the “Quad B” dissenters to APB 23,
Messrs. Bevis, Bows, Broeker, and Burger,
cited noncomparability in noting that “(APB 23) validates a practice …
completely contrary to the underlying concepts of deferred tax accounting … by
sponsoring the idea that certain earnings may be accounted for on an accrual
basis while the related income taxes are accounted for on the cash basis” (APB 23: Accounting for Income Taxes –
Special Areas, April 1972, section 33, p. 6). Also, the cash treatment of taxes
under APB 23 is optional, so a company has total accounting control (i.e., the
choice between cash and accrual) of future U.S. residual taxes.

[4] APB 23 requires “… evidence of specific plans for
reinvestment … which demonstrate that remittance of the earnings will be
postponed indefinitely” (ibid., section
12, p. 4). It might be reasonable for
management in its guidance to say that company value will be enhanced if certain
earnings remain unavailable to shareholders for a few years. However, the
higher standard that should prevail for suppressing a DTL under APB 23 should
be consistent with the maximum time arc of other DTLs such as those arising
from depreciation, because for investors looking at above-the-tax-footnote
financial statements DTLs are effectively homogeneous. If a company believes it might repatriate in
year 19 but under its interpretation of indefinitely for APB 23 only
looked 5 or 10 years out and therefore suppressed the potential DTL
associated with an IRE, and yet the same company or a competitor is carrying
DTLs for depreciation (or, say, pensions) that will not expire for 20 years,
that is inconsistent and confusing to investors trying to gauge earnings
quality. Also, many companies have added to the distortion by asserting
that certain earnings are “permanently” reinvested overseas – this term is not
found in APB 23, and its use raises even a more fundamental question of how
current company management could ever assert such permanence.

[5] Once it is recognized that indefinitely needs to cover
at least 20 years, it would be difficult for any company to make an IRE
designation because current management cannot control circumstances or future
management’s actions. Another concern is
that the current flexibility that company managements have under APB 23 creates
a conflict of interest. This is because the prevalence of equity-based
compensation encourages a company’s management to lower tax expense so as to
increase after-tax earnings and share price. Also, were this attestation made
transparent, it could be Pyrrhic for whomever makes it because if U.S.
management in 2015 openly stated that over $2 trillion of foreign earnings
would be unavailable indefinitely (which should be defined as a minimum of 20
years, as DTLs used for depreciation can last 20 years or more, ditto for DTAs)
to shareholders there likely would be a revolt that would install new
management. As another example of a test
that is not applied under APB 23, the company should be foresighted about
interest rates and how they affect the hurdle rate with respect to
repatriation, because the correlation between the secular decline in interest
rates and the recent huge IRE buildup is not coincidental. Are low interest
rates to be expected for the next 20 years, and if not, how would this affect the
company IRE decision?

If certain earnings are indefinitely
unavailable to shareholders because of an IRE designation, it might be asked
whether the designated earnings should be recorded as unrestricted book income
when earned overseas in the first place because of the company’s self-imposed
mobility restriction. From an investor’s perspective, APB 23 would be
more internally consistent and prudent if instead of suppressing the DTL and
thereby mixing inferior restricted earnings with other types of earnings, the
ruling required a special designation of overseas earnings not intended for repatriation
with the main financial statements excluding (or footnoting) such earnings.

[6] FAS 52 permits some flexibility in presentation of
adverse results, but it does not allow a company to ignore currency translation
just by promising that it would not convert currency under unfavorable circumstances
(i.e., what APB 23 allows). This inconsistency can lead to the odd result that
some companies are badly hurt by hypothetical currency conversion while other
companies are helped by APB 23 designation and hypothetical nonpayment of U.S.
residual tax.The decision about when
to convert foreign-denominated earnings into U.S. dollars seems just as
discretionary for companies as the timing of repatriation; earnings currency
conversion is also a step in repatriation.

1 comment:

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About Me

I am the Wayne Perry Professor of Taxation at New York University Law School. My research mainly emphasizes tax policy, government transfers, budgetary measures, social insurance, and entitlements reform. My most recent books are (1) Decoding the U.S. Corporate Tax (2009) and (2) Taxes, Spending, and the U.S. Government's March Toward Bankruptcy (2006). My other books include Do Deficits Matter? (1997), When Rules Change: An Economic and Political Analysis of Transition Relief and Retroactivity (2000), Making Sense of Social Security Reform (2000), Who Should Pay for Medicare? (2004), Taxes, Spending, and the U.S. Government's March Towards Bankruptcy (2006), Decoding the U.S. Corporate Tax (2009), and Fixing the U.S. International Tax Rules (forthcoming). I am also the author of a novel, Getting It. I am married with two children (boys aged 24 and 21) as well as three cats. For my wife Pat's quilting blog, see Patwig’s Blog.